State Passes a Budget Each Year. By June 15 of each year, the Legislature must pass, and the Governor signs, a budget for the upcoming fiscal year (which runs from July 1 to June 30). The budget includes expectations about how much the state will spend and how much revenue the state will collect over the next year. However, actual revenues and expenditures can vary from these expectations, primarily as a result of changes in the condition of the state economy. For example, if the state passes a budget in June, and then experiences a recession in December, revenues may significantly underperform expectations.

State Has Two Budget Reserves. Budget reserves help insulate the budget from situations where revenues underperform budget assumptions. The state has two budget reserves that fulfill this purpose: the Special Fund for Economic Uncertainties (SFEU) and the Budget Stabilization Account (BSA). Simply put, the SFEU is the difference between state spending and state revenues for a given fiscal year. As such, its balance (the amount by which revenues exceed spending) is the state’s discretionary reserve. The BSA is the state’s mandatory reserve, and its use is governed by certain rules (described later).

Actual Reserves Differ From Enacted Reserves. Figure 1 below describes total reserves (both the SFEU and BSA) over time. (This figure is an interactive version of the one displayed in our 2016 edition of Cal Facts, with some updates and a correction.) The blue bars display enacted reserves, or the amount of combined SFEU and BSA reserves assumed in the annual state budget for the upcoming fiscal year. The dashed line shows actual reserves, or the revised level of reserves estimated by the Department of Finance for the current year, after the state has more information about realized revenues and expenditures. The balanced budget provisions of the State Constitution require the state to enact a budget that is balanced (that is, the balance of the SFEU cannot be less than zero), but actual reserves fluctuate around zero.

Why Do Actual Reserves Fluctuate so Much? State revenues, particularly those from the personal income tax (PIT), are volatile. In particular, the PIT tax base includes capital gains (gains on the sale of stocks, bonds, certain homes, and other assets), which vary considerably from year to year. In many cases, this volatility results in unpredictability. For example, revenues significantly underperformed expectations in the early 1990s recession, the dot.com bust, and the financial crisis and ensuing Great Recession. In the figure, these periods correspond with times when actual reserves were negative. When the economy is expanding, as it did in the mid-to-late 1990s and mid-2000s, revenues generally were much higher than expectations.

Reserves Also Fluctuate in Response to Changes in Expenditures. To a lesser extent, there are factors on the expenditure side that can have an unanticipated effect on the budget’s condition. These factors include, for example, caseload growth in state entitlement programs, the enactment of new legislation, and decisions handed down by the courts. Actual expenditures vary if more (or fewer) people enroll in Medi-Cal, the state’s Medicaid program, or if the federal government changes a law or policy that affects the state’s finances. Like revenues, some of these changes can occur in tandem with economic fluctuations. For example, during periods of recession, the unemployment rate tends to increase, which can result in more people enrolling in means-tested programs like Medi-Cal.

State Budget Reserve Policy Has Changed Over Time. Proposition 58 (2004) established the BSA and required the state to deposit into it a certain percentage of estimated General Fund revenues. Proposition 2 (2014) changed the rules regarding deposits into and withdrawals from the BSA. Specifically, it requires the state to make minimum annual deposits into the BSA based on a percent of overall revenues and capital gains revenues that exceed a historically average threshold. In addition, the state can only suspend a deposit into (or make a withdrawal from) the BSA under a budget emergency, which can only occur under certain fiscal conditions.

Proposition 2 May Improve State Reserve Policy. While Proposition 2 has only been in effect for a few years, it has the potential to improve state reserve policy, and therefore the condition of the budget. In particular, Proposition 2 takes revenues “off the table” in good economic times (focusing on a highly volatile component of revenues: capital gains) and builds budget reserves that can be used during bad times to augment declining revenues. The 2016-17 enacted budget assumed $8.5 billion in total reserves, including $6.7 billion in BSA funds, which represents 7 percent of total General Fund revenues and transfers. As shown in the figure, this is the highest level of reserves in an enacted state budget plan since 1981-82, the first year shown on the graph.